Policy loan taxation refers to how the U.S. tax rules treat loans and loan-related events on cash value life insurance policies. In general, taking a policy loan itself is not a taxable event as long as the contract remains in force and is not a modified endowment contract, because the loan is considered borrowing against collateral rather than a distribution. However, if a non-MEC policy with an outstanding loan is surrendered or lapses, the loan balance is treated as if it were distributed, and any amount above the policyowner's cost basis is taxable as ordinary income. By contrast, MECs are subject to income-first rules under Section 72(e), so loans and withdrawals before age 5912 can be taxed and may incur a penalty. Understanding policy loan taxation is essential for designing supplemental income strategies and avoiding surprises for clients.

In planning, advisors and tax professionals carefully evaluate policy loan taxation when using life insurance for retirement income, business planning or wealth transfer. Many producers rely on non-MEC designs to allow access to cash value through loans without immediate taxation, while monitoring policy performance to avoid lapse with loan. They often collaborate with CPAs and attorneys to confirm basis, track premiums, and document any 1035 exchanges that affect tax calculations. When policies are heavily loaned, in-force illustrations are stress tested to show what happens if interest rates rise or credits fall. If a taxable event has already occurred, tax advisors help clients understand reported gain on Form 1099-R and evaluate options for managing the resulting liability. Clear education about policy loan taxation helps set realistic expectations for "tax-advantaged" income strategies involving life insurance.